In the realm of blockchain, miners and validators play a crucial role in validating new transactions. Their efforts require compensation for the resources and labor involved, naturally leading them to prioritize transactions that offer higher rewards. This dynamic, where transaction fees and block rewards dictate transaction speed, often leads to faster completion of transactions with larger compensations. To optimize their profits further, these block producers may strategically manipulate the system. This collective set of strategies is known as maximal extractable value (MEV).
Maximal extractable value (MEV) involves tactics employed by miners, validators, and searchers to strategically insert, censor, and rearrange transactions to maximize profitability.
While MEV strategies can be advantageous for those manipulating the system, they can have adverse effects on users and blockchain networks.
Common MEV strategies encompass activities like arbitrage on decentralized exchanges (DEXs), back-running, front-running, liquidation manipulation, and sandwich trading.
What is Maximal Extractable Value (MEV)
Maximal Extractable Value (MEV) is a strategic approach utilized by miners, validators, and searchers within blockchain networks to optimize their profitability. This involves the deliberate insertion, censorship, and rearrangement of transactions to achieve the highest possible gains. While MEV can generate profits for those employing these tactics, it often comes at the expense of negative outcomes for both users and the overall network.
Initially introduced as "miner extractable value," MEV originated in 2021, but its influence extends back to earlier blockchain transactions. Originally associated with proof of work (PoW) networks, MEV pertained to the additional value that miners could strategically extract from transaction fees and block rewards by manipulating the order and inclusion/exclusion of transactions in a block. As blockchain ecosystems evolved, including the shift from PoW to proof of stake (PoS) models, the role of miners was succeeded by validators, prompting a shift in the term's meaning. Consequently, MEV now stands for maximal extractable value.
Ethereum, a prominent player in the decentralized finance (DeFi) landscape, is particularly linked with MEV. The transition of Ethereum from PoW to PoS during the Merge marked a pivotal moment in the acronym's transformation, reflecting the evolving nature of blockchain technologies.
Understanding the Mechanism of Maximal Extractable Value (MEV)
Maximal Extractable Value (MEV) operates through the discretion of block producers who hold the power to reorder, include, and exclude transactions within the blocks they produce. These producers prioritize transactions with higher fees to optimize their profits. As they control the block creation process, they can employ various MEV strategies to manipulate transaction placement and maximize returns. An example of such a strategy involves identifying significant transactions that could impact the value of a particular cryptocurrency. By strategically placing transactions just before and after this influential transaction, block producers can capitalize on anticipated price movements. While these strategies are lucrative for block producers, they pose challenges for blockchain users, including inflated gas fees and potential network destabilization.
In proof of work (PoW) consensus mechanisms, miners historically captured around 60% of MEV profits, leaving the rest for MEV searchers. This involvement has persisted within proof of stake (PoS) blockchains. MEV searchers actively explore the blockchain to uncover extractable value, often incurring high gas fees to maximize gains from transactions. To ensure profitability, searchers might allocate over 90% of their income toward gas fees.
Searchers profit by aggregating transactions into bundles based on strategic criteria. These bundles may include transactions from the mempool, executed in a specific sequence. Advanced algorithms executed by bots are frequently used to orchestrate this process.
Searchers employ a range of strategies to extract profits. Using automated bots, they analyze pending transactions, typically focusing on larger ones. Additionally, priority gas auctions (PGAs) have been a tool in their arsenal. PGAs involve increasing gas fees through arbitrage transactions to outbid other users. Unfortunately, PGAs have been linked to negative consequences, including failed attempts that congested block space, increased loads on node operators, fluctuating gas prices, and a competitive advantage for non-searcher miners.
Common MEV Strategies
The pursuit of maximal extractable value involves a variety of strategies that searchers and bots actively employ to identify profitable opportunities among pending transactions. Each of these strategies caters to specific scenarios, and although rarer tactics like uncle bandit attacks and time bandit attacks are utilized in unique situations, let's delve into the more prevalent MEV strategies.
Among these strategies, DEX arbitrage stands out as the most widespread. In this technique, bots vigilantly monitor prices across multiple exchanges. When they spot pricing disparities between exchanges, they execute trades to capitalize on these differences. Profit can be augmented by rearranging transactions or inserting orders, capitalizing on the price gaps.
Nonetheless, the impact of arbitrage on fellow traders is less favorable. Rapidly escalating gas fees orchestrated by bots diminish the profitability of trades for other traders, and slippage can further hinder trading activities.
Back-running involves bots identifying token pair listings that offer profit possibilities. The bot intervenes in pending transactions by positioning itself directly between the token pair. This grants the bot priority when buying tokens, restricting other traders' access to the untapped portion of the token. The bot then holds these tokens until their value appreciates to a predetermined level, at which point they're sold for profit.
Bots also employ the front-running strategy. Upon detecting a substantial trade, the bot mimics the transaction but attaches a higher gas fee. By doing so, the large trade obtains a higher placement in the transaction queue, raising the price of the targeted digital asset. This results in additional profit when the asset is eventually sold.
Both searchers and block producers utilize the liquidation strategy. As users can now borrow against their digital assets, opportunities for extra gains arise. When the collateralized asset's value dips below a pre-defined threshold, the collateral is liquidated to minimize losses for lenders. Transactions causing the asset's value decline and triggering liquidation may yield rewards. Bots identify vulnerable leveraged positions and strategically liquidate collateral to compensate lenders, potentially acquiring discounted assets for subsequent profitable resale.
Sandwich trading, also known as sandwich attacks, involves deploying two bots to encapsulate a targeted transaction. Large transactions can sway token prices, prompting the bots to strategically place an order before and after the transaction. This maneuver allows the searcher to exploit the transaction's impact and derive profit.
MEV strategies can extend to non-fungible tokens (NFTs). Searchers scour the NFT market for lucrative prospects and employ bots to execute transactions. For instance, identifying undervalued NFTs enables searchers to outbid competitors, and in some cases, entire NFT collections have been purchased at base prices to leverage reselling opportunities.
Benefits of MEV
While maximal extractable value (MEV) is often scrutinized for its negative impacts on users and networks, there are several noteworthy advantages to consider as well. MEV is a logical outcome of block validation, as producers naturally aim to optimize their gains. Here are a few key advantages to keep in mind:
Rewards for Miners and Validators
Block producers play a crucial role in the functioning of blockchains like Ethereum. Their task of verifying transactions is essential, but it's not done without compensation. Gas fees and other incentives serve as rewards for their efforts, and these earnings often constitute their livelihood. These fees also contribute to the acquisition of powerful hardware needed for mining. Moreover, these incentives can be utilized to expedite transaction processing, allowing users to strategically position their transactions for faster verification.
Ethereum's PoS Validators
Ethereum's shift to proof of stake (PoS) consensus permits users staking 32 ETH to become validators by creating nodes. This was not feasible in the previous proof of work (PoW) system. Now, a broader spectrum of users can tap into MEV profits. However, it's important to note that while this opportunity is more accessible than before, MEV still demands a high degree of skill. Some users with enough tokens to stake may lack the requisite technical expertise.
Remedies System Inefficiencies
MEV prompts block producers and searchers to address system inefficiencies. For instance, their focus on arbitrage opportunities enables swift price corrections. Furthermore, they identify high-risk loans and aid lenders in recovering their assets from these loans more promptly. Although MEV is often criticized for its adverse effects on users, it paradoxically benefits certain users by rectifying various aspects of the system.
Drawbacks of MEV
Despite its benefits, MEV comes with a set of significant drawbacks that give rise to various issues. In fact, these disadvantages have been recognized as early as 2014, underscoring the challenges associated with MEV that impact both other users of the blockchain and the blockchain ecosystem itself.
Instability and Overload of the Network
The discretionary authority wielded by block producers over transaction ordering and inclusion enables them to extract value from users unknowingly. This dynamic can undermine users' trust in transacting on the blockchain. Furthermore, MEV introduces additional transactions to the network, leading to congestion and subsequently exacerbating the problem of slippage. The potential for destabilization arises when the prioritization of reordering transactions in the previous block becomes more lucrative than focusing on the subsequent block.
Compromised User Experience
Certain MEV tactics, such as front-running and sandwiching, contribute to higher transaction costs and slower processing times for other users' transactions. Consequently, some users might end up paying excessively for their transactions, leading to reduced profitability. Additionally, transaction order adjustments can result in slippage that negatively affects the profitability of specific transactions.
It's noteworthy that certain adverse effects of MEV can be mitigated. For instance, users of decentralized applications (DApps) can execute off-chain trade orders with predetermined order preferences. Consolidating all orders within a single batch ensures uniform transaction pricing, thereby eliminating the potential financial benefit derived from reordering transactions.
MEV in PoW vs MEV in PoS
During ETHUSDT utilization of the PoW (Proof of Work) consensus mechanism, miners possessed complete authority over transaction selection and their consolidation into blocks. These miners made the sole decisions regarding the sequence in which pending transactions were processed. Given the system's inclination to maximize miners' profits, the selection and ordering of transactions naturally favored those with higher fees. Consequently, the term "MEV" denoted "miner extractable value."
On September 15, 2022, Ethereum successfully transitioned from PoW to PoS (Proof of Stake) in what is known as the Merge. Following this transition, validators have assumed the roles formerly held by miners in the PoW setup. Their responsibilities involve validating transactions, for which they receive rewards. As a result, the term "MEV" now stands for "maximal extractable value," applicable to all block producers rather than being limited to miners.
The Future Landscape of MEV
MEV plays a pivotal role in the transaction validation process of blockchains. However, its substantial downsides need to be addressed. As mentioned earlier, some of MEV's negative impacts can be mitigated when users of decentralized applications (DApps) place off-chain trade orders. Certain blockchains have taken steps to tackle MEV-related issues. Chainlink, for example, utilizes Fair Sequencing Services (FSS) to enhance predictability and equity in time-based rankings. Moreover, Layer 2 rollups are leveraged for sorting and scaling transactions.
MEV's influence persists within blockchains and their user communities. To date, limited strategies exist for users to mitigate MEV's full effects. Simultaneously, only a few select blockchains have implemented protocols to prevent manipulative practices by block producers and searchers from adversely affecting other users. Consequently, the topic of MEV will continue to be a focal point in the industry, necessitating the identification and implementation of more comprehensive strategies to prevent undue profits for block providers without incurring negative consequences.
While maximal extractable value strategies offer strategic and financial benefits to blockchain providers, their execution has unfavorable implications for networks and their user base. Advancements are imperative to guarantee the continued efficient and equitable functioning of networks for all stakeholders involved.